Crude contango: As inventories build, oil prices do strange new dance

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On Wednesday, the Energy Information Administration reported that crude inventories jumped by 4.7 million barrels for the week ended Feb. 6. Not only was this much more than the expected increase of 3.4 million barrels, but it serves as further proof that oil inventories continue to build.

It is this supply glut that has led to what's known as a contango price structure in the oil market.

'Contango' means that future oil prices (oil futures) are priced higher than the current (spot) prices. Normally, futures prices are indeed a little higher than the spot price because they account for the cost of carry, such as storage and financing costs. But since the oil market is quite efficient, buying on the spot market and selling in the future doesn't usually yield a profit, despite the price difference. Usually.

These days, there's a premium over and above the normal cost of carry, meaning traders can make decent profits by buying spot and selling futures. For example, you can buy the March contract for light, sweet crude at less than $36 a barrel, and sell futures contracts for delivery next April for $42, or for August delivery for $50. Even taking into account the 35 cents it would cost to store one barrel for a month, and another 35 cents for financing, that's quite a profit. Easy, no?

Well, remember what's been happening in the oil market. There is over-supply and hence storage facilities are quite full -- so much so that oil producers and investors have started to rent tankers that just float around full of oil. Even that extra cost is more than covered by the contango profit. Bloomberg reported last month that Shell and Koch decided there was so much profit to make, they rented four tankers. In a tanker, storage costs 90 cents a barrel per month.

This contango pricing structure has been going on for the past couple of months or so, and should continue as long as inventories continue to pile up. While OPEC has been reducing output, because of lower demand, it needs to cut more for this situation to revert to normal.

Interestingly enough, if it weren't for the credit crunch and the difficulty of some investment players to get financing, an even larger stock might have been built up by now.
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